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ETFs

Fight Inflation With This Low-Cost ETF

Short-term TIPS offer an explicit, direct hedge against inflation, as measured by the U.S. Consumer Price Index.

Inflation has been low for many years, so it is easy to ignore. However, it can still do serious damage over time. For example, inflation that averages the Federal Reserve's target of 2% would reduce a dollar's buying power to $0.67 after 20 years.

Fortunately, Treasury Inflation-Protected Securities provide a way to fight back inflation risk. The principal of TIPS will move in tandem with inflation. It goes up with inflation and goes down with deflation. Once the bond matures, investors receive either the adjusted principal or the original principal, whichever is higher. This means that extended periods of deflation will not erode the principal.

STPZ is a solid, reasonably priced option for exposure to short-term TIPS. However, the fund earns a Morningstar Analyst Rating of Bronze because there are comparable funds available for less.

The fund tracks the market-cap-weighted ICE Bank of America Merrill Lynch 1-5 Year U.S. Inflation-Linked Treasury Index, which includes TIPS with between one and five years until maturity. TIPS offer a direct hedge against inflation. Their principal is adjusted to reflect changes in the Consumer Price Index, which allows investors to preserve their purchasing power. These bonds are issued and backed by the full faith and credit of the U.S. government, so they have minimal credit risk.

The short-maturity-focused mandate gives the portfolio a duration of 3.1 years (as of November 2017), which mitigates interest-rate risk and provides a strong hedge against immediate inflation. Gains and losses from price volatility are muted thanks to the strategy's short duration. As a result, this fund more closely tracks the realized inflation fluctuations over the short-run than its longer-duration counterparts do.

However, the fund's low volatility and high correlation with the inflation rate come at the cost of low expected returns, with a yield of 2% as of this writing. The fund lost 0.1% annually over the five years through November 2017, while its Morningstar Category peers declined by 0.5% over the same period. But it tracked its underlying benchmark closely, lagging the index by 0.22% per year. This gap is in line with the fund's expense ratio of 0.20%; however, there are even lower-cost alternatives.

Fundamental View TIPS are issued with a fixed interest rate but with a variable principal, which is adjusted based on the level of consumer prices, as measured by the two-month-delayed CPI. This index measures the level of prices for a market basket of goods and services that urban consumers buy. The major categories include food, housing, apparel, transportation, medical care, recreation, education, and communication. TIPS apply the fixed rate to the adjusted principal, which changes the semiannual coupon that investors receive, increasing with inflation and decreasing with deflation.

However, traditional U.S. Treasury bonds do take inflation expectations into account and can deliver better real returns at times. If realized inflation is less than the inflation expectations baked into Treasury bond prices, Treasuries would offer better real returns than TIPS. But TIPS come out ahead when the opposite is true. Break-even inflation is the rate that would equate the real return from regular U.S. Treasuries and TIPS with the same maturity. At the end of November 2017, the break-even inflation rate was 1.8%, which was 0.2% lower than the 10-year rolling break-even rate average of 2.0%. If actual inflation exceeds 1.8%, it would reward TIPS investors, but if it is lower than this threshold, U.S. Treasury bonds would come out ahead. Per the Bureau of Labor Statistics, the average inflation rate over the trailing 10 years through November 2017 was 1.7%, slightly below the Fed's medium-term target of 2.0%.

The fund's duration risk is limited. Since the fund's index weights its holdings by market capitalization, its duration can change over time. For example, if the U.S. government issues large quantities of five-year TIPS, the duration of the fund will lengthen and vice versa. However, even if the fund invests 100% of its capital in the five-year TIPS, the duration would be less than five years.

Given its low interest-rate risk, this fund should continue to serve as a strong hedge against short-term inflation. The primary sources of the fund's return are the inflation-indexed coupon payments. Its short duration minimizes price volatility. This fund could be a good option for an investor looking for an instrument that closely reflects immediate shifts in the CPI and inflation.

While the fund offers direct exposure to CPI changes, it offers a low yield. It lost money over the last five years through November 2017 but still landed in the category's top quartile. Its average category peer was down 0.5% per year during the same period. The taper tantrum (2013), which led to the bond market's sharp sell-off, drove the broad TIPS market's recent poor performance. On a risk-adjusted basis, measured by the five-year trailing Sharpe ratio, the fund was on par with the category group. Other TIPS funds offer higher yields but with higher volatility and lower responsiveness to short-term inflation.

Portfolio Construction The strategy earns a Positive Process Pillar rating because it provides a strong hedge against short-term inflation and accurately reflects its target market.

The fund employs full replication to track the ICE Bank of America Merrill Lynch 1-5 Year U.S. Inflation-Linked Treasury Index, which includes TIPS with between one year and five years remaining until maturity. Qualifying issues must also have at least $1 billion par value outstanding. The index held 12 TIPS issues as of December 2017, which it weights by market capitalization. It is rebalanced monthly.

Fees The fund receives a Positive Pillar rating because it is competitively priced relative to its category peers. That said, there are even cheaper index alternatives. Since its August 2009 inception through November 2017, the fund lagged its benchmark by 0.22% annually, which is in line with its expense ratio of 0.20%. Compared with the category average fee of 0.72%, that is an attractive price.

Alternatives

Gold-rated

The largest exchange-traded fund in the category is

FlexShares iBoxx 5-Year Target Duration TIPS Index TDTF and Bronze-rated

In the actively managed realm,

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